Modern Monetary Theory: It's not a Theory, but it's a Dangerous Game
Stephanie Kelton’s The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy represents the first effort by a Modern Monetary Theorist to write a popular book advocating in favor of what is truly a paradigmatic shift in economic thinking as it pertains to debt and monetary and fiscal policy: “That in almost all instances federal deficits are good for the economy,” (Kelton 2020: 2). Further: “The idea that taxes pay for what the government spends is pure fantasy,” (3). The fact that Kelton has largely succeeded—the book is written in straightforward language, replete with simple illustrations and analogies—means that, in all likelihood, there will soon be a surge in those who advocate the policy proposals she puts forth in the latter half of her book based on the theoretical perspective laid out in the former. A federal jobs guarantee, a green new deal, expanded social services—this review concerns itself with none of the lighting rod proposals Kelton advocates; rather, the purpose of this review is to present the theoretical perspective of Modern Monetary Theory as comprehensively as possible. For there is great danger in this book. But arguably even more dangerous, avowed opponents of Modern Monetary Theory seem not to understand the theory they oppose, and so are ill-equipped to answer Modern Monetary Theory advocates in the arena of public debate.
As evidence of this fact, consider the recent email circulated by the Concord Coalition, a bipartisan group committed to eliminating the national debt. It is worth quoting at length: “The rapid rise in federal debt caused by the need to support an economy devastated by COVID-19 has renewed interest in a school of economic thought called Modern Monetary Theory (MMT). It is easy to understand why: MMT provides an economic rationale that absolves politicians from having to pay for new government spending with unpopular tax increases or spending cuts in other areas.” The email goes on in similar fashion, but the headline of the email says it all: “MMT: The New Free Lunch.” Assuming the sincerity of the author of the circular, this is precisely the kind of facile understanding of Modern Monetary Theory that will doom its opponents: For nothing could be further from the truth. As Kelton repeatedly and emphatically emphasizes: “Does that mean there are no limits? Can we just print our way to prosperity? Absolutely not! MMT is not a free lunch,” (37). And: “To be clear, MMT is not about removing all limits. It’s not a free lunch,” (40). Indeed, it is not, and it never was. At its core Modern Monetary Theory is, as Kelton writes: “A nonpartisan lens that describes how our monetary system actually works,” and which seeks to show that when it comes to our domestic economy: “There are limits. However, the limits are not in our government’s ability to spend money, or in the deficit, but in inflationary pressures and resources within the real economy,” (3-4).
I remember well the day Warren Mosler’s slender volume Soft Currency Economics: What Everyone Thinks That They Know About Modern Monetary Policy is Wrong passed into my hands. Mosler is the father of Modern Monetary Theory, and this is the book that started it all. In it, Mosler presents, and ultimately proves, the following series of propositions:
1. Monetary policy sets the price of money
2. The money multiplier concept is backwards
3. Debt monetization cannot and does not take place
4. The imperative behind federal borrowing is to drain excess reserves from the banking system to support the overnight interest rate
5. The federal debt is actually an interest rate maintenance account
6. Fiscal policy determines the amount of new money (Mosler 2012: 14-15)
For, as Mosler explains:
1. Fiat money is a tax credit not backed by any tangible asset
2. In the real world, banks make loans independent of reserve positions, and then during the next accounting period, they borrow any needed reserves. The imperatives of the accounting system, as previously discussed, require the Fed to lend to the banks whatever they need
3. The inelastic nature of the demand for bank reserves leaves the Fed no control over the quantity of money. The Fed only controls the price
4. The market participants who have direct and immediate effect on the money supply include everyone except the Fed
5. As long as the Fed has a mandate to maintain a target Fed funds rate, the size of its purchases and sales of government debt are not discretionary
6. Under a fiat monetary system, the government spends money and then borrows what it does not tax, because deficit spending, if not offset by borrowing would cause the Fed funds rate to fall (16-33)
Blinded by talk of a green new deal and federal jobs guarantee, “free” college, and healthcare for everyone—what opponents of Modern Monetary Theory fail to see through this fusillade of exploding debt and government expansion is that Modern Monetary Theory as a theoretical perspective is irreproachable. In fact, it is not even a theory: it is an explanation of how fiscal and monetary accounting works in the United States and has worked since Nixon cut the dollar loose from gold fifty years ago. For this reason, while not as catchy as “Modern Monetary Theory,” Mosler’s original name for the principles espoused above, “Soft Currency Accounting,” was far more accurate.
If the above explanation was too technical, or you are otherwise skeptical, you are not alone—far from it. Terrifyingly, our nation’s top law makers and budgeters are equally in the dark about their own government’s debt, and monetary and fiscal policy. Consider this extended anecdote from Kelton, writing about her time as an economist on the Senate Budget Committee:
One of the most eye-opening things I learned came from a game I would play with members of the committee (or their staffers). I did this dozens of times, and I always got the same incredible reaction. I’d start by asking them to imagine that they had discovered a magic wand with the power to eliminate the entire national debt with one flick of the wrist. Then I’d ask, “Would you wave the wand?” Without hesitation, they all wanted the debt gone. After establishing an unflinching desire to wipe the slate clean, I’d ask a seemingly different question: “Suppose that wand had the power to rid the world of US Treasuries. Would you wave it?” The question drew puzzled looks, furrowed brows, and pensive expressions. Eventually everyone would decide against waving the wand (Kelton 2020: 77).
While Kelton’s own reaction to this was: “I found it fascinating!” (77), my own reaction was a simple, depressed, “Wow…” Because, of course, the treasuries are the debt.
With the aim of making Mosler’s more technocratic jargon comprehensible to her audience of lay readers, Kelton frames Modern Monetary Theory as a myth-buster, and uses it to dispel the following myths:
MYTH #1: The federal government should budget like a household.
This is wrong, because, as Kelton explains, the crucial difference between the federal government and a household is that: “Unlike a household, the federal government issues the currency it spends,” (15). The US government literally cannot run out of money. If it printed too much it would lose value and ultimately become worthless, but that is not what we are talking about. In her own parlance, the federal government is a “currency issuer,” unlike a household or state government which is a “currency user.”
MYTH #2: Deficits are evidence of overspending.
This is wrong as well. Government spending is nothing but an increase in the total money supply, and so overspending, as Kelton points out: “Manifests as inflation,” (42). Subsequently, if there is no inflation on the horizon there is no danger in spending more—at least, so the theory goes.
This is one of the true dangers of the policy proposals Modern Monetary Theorists advocate, and one of the principal reasons I wrote this review. This point will be returned to later, for MMT requires something completely beyond the government: an increase in fiscal and monetary responsibility (44).
MYTH #3 As far as the national debt goes: we’re all on the hook.
The reality, however, is that the national debt is simply: “A historical record of how many dollars the federal government has added to people’s pockets without subtracting (taxing) them away. Those dollars are being saved in the form of US Treasuries,” (79). As a “currency sovereign,” a government that controls its own currency: “The currency issuer’s spending is self-financing. It’s not selling bonds because it needs the dollars. Bond sales just allow holders of reserve balances to trade them in for US Treasuries. It’s done to support interest rates, not to fund the government,” (87).
Theoretically the Federal government could redeem (pay) all its debt right now. It would be a simple accounting exercise: moving the numbers in everyone’s proverbial checking account at the Fed to their savings account at the Fed. If it helps, think of Treasuries as dollars you get paid interest for holding. No holder would want them all cashed in because doing so would cause an enormous overnight expansion of the money supply, destroying the value of their holdings. The Federal government also would not want this because it would bring interest rates to zero. It is really that simple.
This was not always the case, of course. Under the pre-1971 system there was a real constraint on government spending, as dollars could be redeemed on demand for gold. This has not been true since the US dollar began floating, however, and much of the misguided thinking about modern government finance can be traced back to an ossified way of thinking about government finance that remains tied to pre-1971 thinking.
In fact, much of the confusion stems from one basic misunderstanding about how modern government finance works. As Kelton explains: “According to conventional thinking, the government relies on two sources of funding: it can raise your taxes or it can borrow your savings […] In either case, the idea is that the government must come up with the money before it can spend (21). The truth, however, is that has the reality completely backward: “The government doesn’t need our money. We need their money.” As Warren Mosler put it:
The government doesn’t want dollars […] It wants to provision itself […] The tax isn’t there to raise money. It’s there to get people working and producing things for the government […] A military, a court system, public parks, hospitals, roads, bridges […] To get the population to do all that work, the government imposes taxes, fees, fines, or other obligations. The tax is there to create a demand for the government’s currency. Before anyone can pay the tax someone has to work to earn the currency (24-25).
As Kelton writes: “Mosler explained that most of us had the sequencing wrong. Taxpayers weren’t funding the government, the government was funding the taxpayers,” (Kelton 2020: 27).
And this all ties into MYTH #4: Government deficits crowd out private investment.
To be clear, it can, and Kelton admits this (109, 112). However, just on a basic theoretical level: The government deficit equals the private sector surplus (106). Think about it: the money being pumped into the economy goes into the private sector. As Kelton explains: “Suppose the government spends $100 into the economy but collects just $90 in taxes. The difference is known as the government deficit. But there’s another way to look at that difference. Uncle Sam’s deficit creates a surplus for someone else,” (9). The confusion, as Kelton points out, stems from the mistaken notion that: “There’s a fixed supply of savings from which anyone can attempt to borrow,” (113).
This, again, goes back to the pre-1971 mindset most people who think about the debt and government finance are stuck in. As economist Scott Fullwiler correctly says: “[This conventional] analysis is simply inconsistent with how the modern financial system actually works,” (113). As Kelton further explicates, drawing on the economic modeling of Wynne Godley: “Government deficits always lead to a dollar-for-dollar increase in the supply of net financial assets held in the nongovernmental bucket. That’s not a theory. That’s not an opinion. It’s just the cold hard reality of stock-flow consistent accounting,” (116).
If it is not clear already, the relationship between deficits and interest rates is that: “Deficits push the overnight interest rate down. In a world without bond sales or some other defensive action by the central bank, deficits will drive the short-term interest rate to zero. That’s because deficit spending fills the banking system with excess reserves, and a huge increase in the supply of reserves will push the federal funds rate to zero,” (121).
In the end, the theory that government “borrowing” crowds out private investment, while it can be true, generally isn’t. As Timothy Sharpe showed in a comprehensive analysis of countries that were “monetary sovereigns,” like the United States, England, and Japan, who completely control their own currencies, versus those that weren’t, like Greece, Panama, and Argentina: “The empirical evidence reveals crowding-out effects in non-sovereign economies, but not within sovereign economies,” (126).
While Kelton takes on two additional myths—related to trade and entitlement spending—they are inextricably tied to policy proposals, which as stated in the opening are beyond the scope of this review. And so, before concluding, let’s take a look at three final things: inflation, the inability of the government to correctly predict it, and the inability of the federal government to control its spending even without embracing the MMT lens.
As we know already: inflation is a sign of government overspending. And while Kelton writes: “A little bit of inflation is considered harmless and even something economists like to see in a healthy, growing economy,” she also acknowledges that: “If prices start rising faster than most people’s incomes it means a widespread loss of purchasing power. Left unchecked, this would mean a decline in society’s real standard of living. In extreme cases, prices can even spiral out of control gripping a country in hyperinflation,” (44). As anyone who has taken an introductory economics course knows, this happens when too much money is chasing too few goods. And this all strikes me as potentially problematic, for as Kelton further writes:
It’s not the printing of money, per se, but the spending of money that matters. If the government wants to boost spending on health care and education it may need to remove some spending power from the rest of us to prevent its own more generous outlays from pushing up prices. One way to do this is by coordinating higher government spending with higher taxes so that the rest of us are forced to cut back a little to create room for additional government spending (33).
Preventing inflation is in large part then, a political issue. Looking at the partisanship in Congress today, one can say definitively that is not an auspicious proposition to be faced with, particularly as Kelton admits both parties regularly use government finance as a political weapon against the other (22).
Fundamentally, as Kelton admits in opening, Modern Monetary Theory is not: “To suggest that deficits don’t matter, so we can throw caution to the wind and simply spend, spend, spend. The economic framework that I’m advocating for is asking for more fiscal responsibility from the federal government, not less,” (12). And this is precisely one of the problems. Even Kelton occasionally falls into the trap Congress would, provided it wasn’t trying to use the deficit as a political weapon: “Having monetary sovereignty means that a country can prioritize the security and well-being of its people without needing to worry about how to pay for it,” (20). But you do, because inflation will destroy the purchasing power of the dollars the average person is spending and which they desperately need.
Which brings us to the difficulty of predicting and managing inflation. Kelton thoroughly and properly excoriates the Fed for its inability to do its part in this. At present the Fed uses a labor market metric to predict inflation, the NAIRU (non-accelerating inflationary rate of employment), and as Kelton writes: “It is indisputable that the Fed’s recent estimates of the NAIRU—the level of unemployment that can be achieved without causing inflation to accelerate have been consistently wrong,” (53). Kelton believes she has solved this problem with her federal jobs guarantee, but this simply shifts the burden of predicting inflation elsewhere. While the human cost may be lower, it may turn out not to be if inflation is incorrectly predicted, sets in, and destroys the economy by ruining the purchasing power of the dollar.
In conclusion: Know your enemy. Modern Monetary Theorists are not the enemy: Government profligacy is. And while Kelton is more than aware of this, in order to advocate the proposals she does she also seems to have necessarily partitioned off her knowledge that: Congress is terrible at working together toward our common good, can’t stop spending as it is, the Fed is terrible at predicting inflation, and inflation is the doomsday machine of every economy—sovereign currency issuer or not. At the same time, fiscal conservatives like those of the Concord Coalition, by closing their eyes and pretending Modern Monetary Theorists are some special kind of economic ignoramus, ignore the very real insights the lens of Soft Currency Accounting provides about how government finance and the economy work, and further blind themselves to a whole array of possible policy options available in light of understanding how debt, and fiscal and monetary policy actually work.
At the end of the day, advocates of MMT generally propose dangerously inflationary policies, while those who oppose them do not properly understand what they are criticizing, and so do a poor job of it. It should be clear that this is not the combination we want mixing in the halls of Congress. As a Libertarian and Austrian I am roundly horrified by what I see. But this is not about the relative merits of deregulating currency, of ending central banking, or even of re-pegging the dollar. This is about spreading understanding of where we are, what is going on, and what we should do considering that understanding. Make no mistake: we have come to a dangerous place, made even more dangerous by the confusion surrounding our present circumstances. My hope is that this succinct review of Stephanie Kelton’s recent book length treatment of Modern Monetary Theory, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, has helped to clarify the actual terms of the debate, particularly for interested fiscal conservatives.
Kelton, S. (2020) The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. Public Affairs: New York.
Mosler, W. (2012) Soft Currency Economics II: The Origin of Modern Monetary Theory. Valance: Christiansted.